Taking a second look

Why the SEC is once again probing the secondaries market.

This week we broke the news that the Securities and Exchange Commission is taking a closer look at secondaries transactions.

In case you missed it, the US regulator has been getting to grips with the role that a general partner plays when a limited partner in one of its funds wants to sell out.

This is not the first time the SEC has sought to get under the skin of the secondaries market. In late 2015 commission officials started making public comments about the potential for conflicts of interest in GP-led fund restructuring and stapled transactions. There is plenty of scope for these processes, which are instigated by the manager, to produce a misalignment of interest, as explored at the time by sister publication Secondaries Investor.

Now, however, it is looking at the more straightforward, and seemingly less controversial, area of individual fund stake sales. This may come as a surprise to some, given that these processes are initiated by the LP and there seems to be less scope for abuse. The owner of the stake assesses the bid or bids and decides whether or not to move forward.

So what could the SEC be worried about in these relatively vanilla transactions? Market sources suggest a few areas that could give the commission cause for concern.

One is a question of the limited partner’s motivations for selling and whether all LPs benefit from the same information. The SEC will want to be sure that the selling LP did not have knowledge that other investors lacked which motivated it to sell at that point in time. If there is some sort of special relationship between the GP and that particular LP – where information could be flowing through backchannels – then this is a problem.

Another is whether the GP is being fair and transparent when suggesting buyers. It is no secret that managers will favour certain LPs over others; specifically those likely to commit to future funds over those who may not. At the same time an LP looking to sell will often rely on the GP to introduce potential buyers. If the GP is selective in who they suggest, then they would be narrowing the pool of bidders to the potential detriment of the investor.

If the GP itself is the buyer, then the SEC will want to see transparency around the valuation process.

A more theoretical risk concerns whether the status of a fund as a privately placed security is in jeopardy. If a fund is deemed to be publicly traded then it becomes a totally different class of security with a totally different regulatory profile. This is a long way off, says one fund lawyer, but secondaries is “a brave new world”, he says, and with the advent of exchanges to facilitate secondaries trades, it is an area to keep an eye on.

In the absence of an industry standard way of handling a secondaries sale, compliance experts tell us that what the SEC wants to see above all else is due process and transparency. GPs would do well to bear this in mind.